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The Economics of Severance Pay

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  • Pietro Garibaldi

Abstract

All OECD countries have either legally mandated severance pay or compensations imposed by industry-level bargaining in case of employer initiated job separations. According to the extensive liter- ature on Employment Protection Legislation (EPL), such transfers are either ineffective or less efficient than unemployment benefits in providing insurance against labor market risk. In this paper we show that mandatory severance is optimal in presence of wage deferrals when there is moral hazard of workers, shirkers can get away with it and adverse selection prevents employers to commit not to fire a non-shirker. Our model also accounts for two neglected features of EPL. The first is the discretion of judges in inter- preting the law, which relates not only to the decision as to whether the dismissal is deemed fair or unfair, but also to the nature, economic vs. disciplinary, of the layoff. The second feature is that compensation for dismissal is generally increasing with tenure. We provide new cross-country comparable measures of these two features of EPL. The model also explains why severance is generally higher in countries with less efficient judicial systems and why small firms are typically exempted from the strictest EPL provisions.

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  • Pietro Garibaldi, 2014. "The Economics of Severance Pay," 2014 Meeting Papers 342, Society for Economic Dynamics.
  • Handle: RePEc:red:sed014:342
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    References listed on IDEAS

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    Cited by:

    1. Siassi, Nawid & Dolado, Juan J. & Lalé, Etienne, 2015. "Moving Towards a Single Labor Contract: Transition vs. Steady State," Annual Conference 2015 (Muenster): Economic Development - Theory and Policy 112858, Verein für Socialpolitik / German Economic Association.
    2. Dolado, Juan J. & Lalé, Etienne & Siassi, Nawid, 2016. "From Dual to Unified Employment Protection: Transition and Steady State," IZA Discussion Papers 9953, Institute of Labor Economics (IZA).
    3. Boeri, Tito & Jimeno, Juan F., 2016. "Learning from the Great Divergence in unemployment in Europe during the crisis," Labour Economics, Elsevier, vol. 41(C), pages 32-46.
    4. Kerndler, Martin, 2016. "Contracting frictions and inefficient layoffs of older workers," Annual Conference 2016 (Augsburg): Demographic Change 145711, Verein für Socialpolitik / German Economic Association.

    More about this item

    JEL classification:

    • J63 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Turnover; Vacancies; Layoffs
    • J65 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Unemployment Insurance; Severance Pay; Plant Closings
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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